Possibly a Tactical Chance for Bonds

This week, I am participating in a school-style debate at the Global Fixed
Income Institute's conferences in Madrid where the question before the house
is whether or not inflation will resurface in major world economies in the
next five years. As you might imagine, I feel that my part of the debate is
the easy part, especially as inflation is pointing higher in the US and core
inflation just surprised higher in Europe. However, I am sure the other side
feels the same way.

The Institute is interested in this discussion partly to illuminate the question
of whether the substantial rise in yields over the last three months or so
in all developed bond markets (see chart, source Bloomberg, showing 10y yields
in US, UK, Germany and Japan) is indicative of a return of fears of inflation.

The ironic part of this is that I do not believe that the rise in yields
has much if anything to do with the expectation for higher inflation. Partly,
it is due to a subtle sea change in the way investors are thinking about the
prospects for central bank policy - to wit, the possibility (which I see as
slim) that the Fed chooses to raise rates meaningfully above zero in the next
year, starting in September. But to some degree, the market has been discounting
higher forward rates for a very long time. It has been consistently wrong on
that point, but the steeply sloped yield curve (the 2y/10y spread hasn't been
flatter than 120bps since early 2008 - see chart, source Bloomberg) implies
higher forward rates.

The rise in yields, in my view, is partly related to the prospect for
changes in central bank policy, but also partly (and more sinisterly) related
to the continuing intentional destruction by policymakers of the ability
of large banks and dealers to make markets. We see worse liquidity in more
and more markets almost by the day (as predicted five years ago in this space,
for example here and here,
as well as by many other observers). Less liquid markets tend to trade with
more volatility, as it gets harder to move institutional size, and at lower
prices since holders of assets need to factor in the difficulty of selling
a position. Higher yields are going to happen in any event, and when institutional
holders of bonds decide to diversify into commodities or into other real assets,
interest rates could rise quickly depending how quickly that meme spreads.
Of course, the same is true of equities, and commodities. Asset-allocation
shifts will get messier.

I actually think this isn't a bad time tactically to enter long positions
in fixed-income. The Fed isn't going to be as aggressive as people expect;
also, bonds will get some support from investors fleeing fading momentum in
stocks. The chart below (source: Bloomberg; Enduring
Investments calculations) shows the 52-week price change in stocks. This
is one measure of momentum, and a very important one as lots of investors look
at their returns in annual chunks. Incredibly, since the latter part of 2012
investors have always been able to see double-digit returns from stocks when
they looked in the rear-view mirror. Today, that number is 7.5%.

That's still a terrific real return of more than 5%, but (a) many investors
have very screwy return expectations, (b) many investors are well aware that
they've been living on borrowed time with a liquidity-inspired rally, and (c)
certain quantitative investors place significant weight to momentum, over value,
in their investment models.

It's just another red flag for stocks, but it has become passé to point
them out. From the standpoint of a bond investor, though, this is good news
because all of those equity owners, when they decide to take their chips off
the table, will become bond buyers.

And when that happens, the liquidity issues in fixed-income might cut the
other way for a while.

You can follow me @inflation_guy!

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Michael Ashton is Managing Principal at Enduring
Investments LLC, a specialty consulting and investment management boutique
that offers focused inflation-market expertise. He may be contacted through
that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist,
and salesman during a 20-year Wall Street career that included tours of duty
at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation
derivatives markets and is widely viewed as a premier subject matter expert
on inflation products and inflation trading. While at Barclays, he traded
the first interbank U.S. CPI swaps. He was primarily responsible for the creation
of the CPI Futures contract that the Chicago Mercantile Exchange listed in
February 2004 and was the lead market maker for that contract. Mr. Ashton
has written extensively about the use of inflation-indexed products for hedging
real exposures, including papers and book chapters on "Inflation and Commodities," "The
Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven
Investment For Individuals." He frequently speaks in front of professional
and retail audiences, both large and small. He runs the Inflation-Indexed
Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes
for client distribution and more recently for wider public dissemination.
Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University
in 1990 and was awarded his CFA charter in 2001.